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“The Economic Way of Thinking” 10th Edition by Paul Heyne, Peter Boettke, and David Prychitko “Opportunity Cost and the Supply of Goods” PowerPoint Slides prepared by Assistant Professor Paul Harris Camden County College The Economic Way of Thinking 10e ©Prentice Hall 2003 1 Chapter Outline I. Introduction II. Refresher on Opportunity Cost III. Cost are tied to Actions, Not Things IV. The Irrelevance of “Sunk Cost” V. Producers’ Cost as Opportunity Cost VI. Marginal Cost as Opportunity Cost VII. Marginal Opportunity Cost VIII.Cost and Supply 2 The Economic Way of Thinking 10e ©Prentice Hall 2003 Chapter Outline IX. Marginal and Average Cost X. The Cost of a Volunteer Military Force XI. Price Elasticity of Supply XII. Cost as Justification XIII.Once over lightly 3 The Economic Way of Thinking 10e ©Prentice Hall 2003 Introduction The theory of supply, like demand theory, assumes that decision makers face alternatives and choices. These choices are based on a comparison of expected benefits and cost. The incentive to produce and supply scarce goods is shaped by opportunity cost, and the market prices that reflect and inform us of those cost. 4 The Economic Way of Thinking 10e ©Prentice Hall 2003 Refresher on Opportunity Cost Question…. Why do poor people travel between cities by bus, while wealthy people are more likely to travel by air? Answer……. The higher one’s income, the higher the opportunity cost of time. 5 The Economic Way of Thinking 10e ©Prentice Hall 2003 Refresher on Opportunity Cost Question…. Why is it so much harder to find a teenage babysitter in a wealthy residential area than a low- income area? Answer……. Wealthier people go out more so they demand more babysitting services, while wealthy teenagers get generous allowances, so they value a date or leisure time more than the extra money they could earn babysitting. 6 The Economic Way of Thinking 10e ©Prentice Hall 2003 Costs are Tied to Actions, Not Things Costs are always tied to actions, decisions, and choices. We must first distinguish the cost of obtaining a good or service, from the cost of providing one. The true cost of things stems from a failure to recognize that only actions have cost, and that actions can entail different costs for different people. 7 The Economic Way of Thinking 10e ©Prentice Hall 2003 The Irrelevance of “Sunk Cost” With cost, the most common error is to confuse cost previously incurred with marginal cost. The proper stance for making cost calculations is not to look at the past, for the past is filled with sunk cost, irretrievable cost. The proper stance is to look forward to current opportunity cost. Marginal cost always lies in the future. Sunk cost represent no opportunity for future choice. 8 The Economic Way of Thinking 10e ©Prentice Hall 2003 Producers’ Cost as Opportunity Cost The concept of opportunity cost asserts that the amount of money a producer must pay for any resource, human or physical, will depend upon what the owner of that resource can obtain from someone else. The resource that more clearly illustrates the opportunity cost concept is probably land. Land can be used for residential, commercial, or industrial purposes. The cost you pay for the land will be determined by the alternative opportunities that people perceive for its use. The Economic Way of Thinking 10e ©Prentice Hall 2003 9 Marginal Opportunity Cost All opportunity cost are marginal cost and all marginal cost are opportunity cost. Opportunity cost calls attention to the value of the opportunity forgone by an action. Marginal cost calls attention to the change in the existing situation that the action entails. The full name for any cost that is relevant to decision making is “marginal opportunity cost”. All such cost are cost of actions, or decisions; all are attached to particular persons; and all lie in the future. 10 The Economic Way of Thinking 10e ©Prentice Hall 2003 Cost and Supply • Farmer Smith considers producing soybeans and corn this season. • If he devotes all of his acreage to soy production, he can produce 14.5 units • If he produces corn instead, he can produce 10 units. • The table on the next slide shows his other production possibilities. 11 The Economic Way of Thinking 10e ©Prentice Hall 2003 Cost and Supply Soybean Output per Harvest Corn Output per Harvest 14.5 0 13.5 1 12.4 2 11.2 3 9.9 4 8.5 5 7.0 6 5.4 7 3.7 8 1.9 9 0 10 The Economic Way of Thinking 10e ©Prentice Hall 2003 12 Cost and Supply The marginal cost of a second unit of corn is 1.1 units of soy. Soybean output per harvest 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Smith’s production possibilities for corn and soy. The marginal cost of Producing a 9th unit Of corn is 1.8 units of Soybeans. ` 1 2 3 4 5 6 7 9 10 11 12 Corn output Per harvest The Economic Way of Thinking 10e ©Prentice Hall 2003 13 13 Cost and Supply The data on the preceding slide indicates increasing opportunity cost of producing each good. Smith has to be concerned with the relative prices of both soy and corn to make his production decisions. Based on the relative prices, producers consider marginal cost of production when deciding upon which outputs, and which levels of output to produce. 14 The Economic Way of Thinking 10e ©Prentice Hall 2003 Cost and Supply Relative prices further informs producers of the marginal cost, and the marginal benefits, of their alternative production plans. The supply curve for corn is an upward sloping curve which reflects the marginal cost of producing corn. The area under the curve reflects the total cost of production. The supply curve illustrates the alternative amounts of a good supplied at alternative prices. 15 The Economic Way of Thinking 10e ©Prentice Hall 2003 Cost and Supply Price $0.20 $0.40 $0.60 $0.80 $1.00 $1.20 $1.40 $1.60 $1.80 $2.00 Units of Corn 1 2 3 4 5 6 7 8 9 10 Supply Schedule for Corn. 16 The Economic Way of Thinking 10e ©Prentice Hall 2003 Cost and Supply Supply Curve for Corn Units of Corn 12 Price 10 8 Units of Corn 6 4 2 0 1 2 3 4 5 6 7 8 9 10 Quantity 17 The Economic Way of Thinking 10e ©Prentice Hall 2003 Marginal and Average Cost • Marginal cost is not the same as average cost. – Marginal cost reflects the change in total cost from producing one more unit. – Average Cost is total cost divided by the number of units produced. • Marginal cost is the consequence of action; therefore it should be the guide to action. – Economic decisions are always made with an eye towards the future. 18 The Economic Way of Thinking 10e ©Prentice Hall 2003 Marginal and Average Cost Units of Corn produced 0 Total Cost of Producing corn 0 Marginal Cost Average Cost 0 0 1 $1 $1 $1 2 $2.10 $1.10 $1.05 3 $3.30 $1.20 $1.05 19 The Economic Way of Thinking 10e ©Prentice Hall 2003 The Cost of a Volunteer Military Force • Since 1999 there has been a concern about enlistment and recruitment shortages in the military. – As a result there have been arguments for initiating a draft. – But is a draft the less costly way to organize a military force? • The “cost” we are referring to is the cost to the taxpayer. 20 The Economic Way of Thinking 10e ©Prentice Hall 2003 The Cost of a Volunteer Military Force • The best way to determine the cost of a soldier is to offer a bribe and keep raising it until it is accepted. – Or you could simply pay low wages and force everyone to join with a draft. • The opportunity cost of serving in the military is the forgone wages that could be earned in other occupations. 21 The Economic Way of Thinking 10e ©Prentice Hall 2003 The Cost of a Volunteer Military Force When the government bids for military personnel it should raise its offer price until it can get the exact number of enlistments it needs. Studies show that the wage offer should be at least $16,000 per year. Will the taxpayers go for it? 22 The Economic Way of Thinking 10e ©Prentice Hall 2003 Price Elasticity of Supply • Price Elasticity of Supply is calculated by taking the % change in quantity supplied in the numerator, divided by the % change in price in the denominator. • Price and quantity supplied are directly related, so regardless of the elasticity, when prices rise, total revenue rises, and when prices fall total revenue falls. • Time is the major determinant of Price Elasticity of Supply. 23 The Economic Way of Thinking 10e ©Prentice Hall 2003 Price Elasticity of Supply • If producers do not have the time to secure additional resources when prices change, supply will be perfectly inelastic. • With time to react to price changes supply becomes more elastic. – If the percentage in quantity supplied is greater than the percentage change in price, then supply will be elastic. – If the percentage change in quantity supplied is less than the percentage in change in price, then supply will be inelastic. 24 The Economic Way of Thinking 10e ©Prentice Hall 2003 Cost Justification • Many people think that prices should be related closely to cost. • They think that if prices are significantly above cost then producers are pursuing some unfair advantage. – This way of thinking is known as justification. – Cost is always the product of supply and demand. 25 The Economic Way of Thinking 10e ©Prentice Hall 2003 Once Over Lightly Supply curves reflect people’s estimates of the value of alternative opportunities. Quantity supplied and demanded depends on the economizing choices based on the opportunity costs of people. Cost is the value of opportunities that people sacrifice. The Economic Way of Thinking 10e Past expenditures cannot be affected by present decisions. These are sunk cost. Opportunity cost is necessarily marginal cost. Supply depends on cost. The cost of supplying is the value of the opportunities forgone by the act of supplying. 26 ©Prentice Hall 2003 Once Over Lightly There is a direct relationship between price and quantity supplied. The supply curve slopes upward and to the right. Price Elasticity of Supply is the% change in quantity supplied divided by the % change in price. Only actions have cost. Ask yourself “cost to whom”, “cost of doing what?” 27 The Economic Way of Thinking 10e ©Prentice Hall 2003 Next Chapter 5 Supply and Demand: A Process of Cooperation End of Chapter 4 28 The Economic Way of Thinking 10e ©Prentice Hall 2003